Why Earnings Don't Drive Stock Prices
Bove, Rochard X., American Banker
The stock market has not performed particularly well this year, up only about 1%. The S&P 500 average closed 1991 at 417, and on Tuesday, it was at 422.92. This has created consternation among two groups of market investors:
* Those who expected that S&P earnings might jump to $23 this year from the $15.97 a share recorded last year.
* Those who feared the economy would falter for a third time in two years, causing earnings to be disappointing.
The groups disagreed on the direction of earnings, but both believed that earnings drive stock prices.
Therefore, they are now perplexed because the stock market is not moving in the direction they think earnings will go.
The fact is, earnings are no the most important factor in stock pricing. The most important factors are money flows second are rate expectations while earnings rank third.
Facts Speak for Themselves
Since most bank executive concentrate on building earnings to improve their stock price, and Wall Street has a large subindustry that does nothing but make earnings estimates, it may seem inane to claim that earnings are a tertiary consideration in stock prices. However, the facts are clear:
* In the 1970s the S&P 500 rose 2.5% per year. Earnings rose much more rapidly - 10.5% annually during that decade - perhaps the fastest growth on record. Clearly, the market and corporate profits were not in sync.
* In the 1980s. stock prices rose 11.4% annually, earnings only 4.1%. Most of the stock price growth occurred in the first part of the decade. when earnings were not expanding. When earnings growth picked up in the later years, stock price growth slowed.
* So far in the 1990s, the stock market has almost completely ignored earnings. The S&P 506 profits fell 30.1% from Dec. 31, 1989, to Dec. 31, 1991, but the S&P stock index rose 19.6%. In 1992, earnings have rebounded significantly and stock prices ave remained flat.
These trends are not merely modern-day phenomena. From 1935 to 1940, S&P earnings grew 29% and stock prices fell 21%. From 1940 to 1945, earnings fell 26% and stock prices rose 64%. Then earnings soared 265% from 1945 to 1949 and stock prices fell 3%.
In 1949, stock prices were at the same level as in 1936, despite the fact that the nation had gone from a depression to a postwar boom.
The explanation for these conflicting movements is that money flows into the sector that is expected to offer the highest immediate profit. When the yield on economic activity is perceived to be high, money flows out of the financial sector and into inventories, receivables, and capital expenditures.
Conversely, when the returns on inventories, receivables, and capital spending falter, funds return to the financial markets. The stock market leads the economy up (or down) because it gets the impact of excess (or depleted) financial flows first.
The Cycle at General Motors
Consider what happens at General Motors through an economic cycle.
When demand for automobiles increases, the company treasurer begins redeeming short-term investments to buy steel, hire labor, and build cars.
As demand continues to grow, GM may actually borrow money in the open market to expand plant facilities. The company goes from being a net provider of funds to a net user.
When the economy weakens, the treasurer reverses course. Funds are withheld from car production, the returns on which have turned negative, and go toward paying off debt. Ultimately they are used to buy securities. GM has become a net provider of funds.
Weak Economy Helps Stocks
By making rational judgments on expected returns, the corporate treasurer moves funds into and out of the financial markets. Thus, bond and stock prices do better when the economy is weak and there is no competition for funds. …